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Dynamic Credit Relationships in General Equilibrium

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  • Smith, A. A.
  • Wang, Cheng

Abstract

We construct a general equilibrium model with private information in which borrowers and lenders enter into long-term dynamic credit relationships. Each new generation of ex ante identical individuals is divided in equilibrium into workers and entrepreneurs. Workers save through financial intermediaries in the form of interest-bearing deposits and supply labor to entrepreneurs in a competitive labor market. Entrepreneurs borrow from financial intermediaries to finance projects which produce privately observed sequences of random returns. Each financial intermediary holds deposits from a large number of workers and operates a portfolio of dynamic contracts with different credit positions. We calibrate the model to the U.S. economy and find that dynamic contracting is very effective at mitigating the effects of private information. Moreover, restricting borrowers and lenders to use static (one-period) contracts with a costly monitoring technology has adverse effects both on the level of aggregate econonmic activity and on individual welfare unless monitoring costs are very small. Finally, the optimal provision of intertemporal incentives leads to increasing consumption inequality over time within generational cohorts as in U.S. data.

Suggested Citation

  • Smith, A. A. & Wang, Cheng, 2006. "Dynamic Credit Relationships in General Equilibrium," Staff General Research Papers Archive 12263, Iowa State University, Department of Economics.
  • Handle: RePEc:isu:genres:12263
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    References listed on IDEAS

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    1. Greenwood, Jeremy & Sanchez, Juan M & Wang, Cheng, 2007. "Financing Development: The Role of Information Costs," Staff General Research Papers Archive 12848, Iowa State University, Department of Economics.
    2. Thomas Cooley & Ramon Marimon & Vincenzo Quadrini, 2004. "Aggregate Consequences of Limited Contract Enforceability," Journal of Political Economy, University of Chicago Press, vol. 112(4), pages 817-847, August.
    3. Sebastian Dyrda, 2015. "Fluctuations in uncertainty, efficient borrowing constraints and firm dynamics," 2015 Meeting Papers 1243, Society for Economic Dynamics.
    4. Pavan, Marina, 2008. "Consumer durables and risky borrowing: The effects of bankruptcy protection," Journal of Monetary Economics, Elsevier, pages 1441-1456.
    5. Jeremy Greenwood, 2007. "Financing Development: The Role of Information Costs," 2007 Meeting Papers 171, Society for Economic Dynamics.
    6. Cheng Wang, 2000. "Renegotiation-Proof Dynamic Contracts with Private Information," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 3(3), pages 396-422, July.
    7. Pavan, Marina, 2008. "Consumer durables and risky borrowing: The effects of bankruptcy protection," Journal of Monetary Economics, Elsevier, pages 1441-1456.
    8. Jeremy Greenwood & Juan M. Sanchez & Cheng Wang, 2010. "Financing Development: The Role of Information Costs," American Economic Review, American Economic Association, pages 1875-1891.
    9. Jeremy Greenwood & Juan M. Sanchez & Cheng Wang, 2010. "Financing Development: The Role of Information Costs," American Economic Review, American Economic Association, pages 1875-1891.
    10. Nikolov, Kalin, 2011. "A model of borrower reputation as intangible collateral," MPRA Paper 32939, University Library of Munich, Germany.
    11. Cheng Wang, 1995. "Dynamic Insurance with Private Information and Balanced Budgets," Review of Economic Studies, Oxford University Press, vol. 62(4), pages 577-595.
    12. Martin Andreasen & Marcelo Ferman & Pawel Zabczyk, 2013. "The Business Cycle Implications of Banks' Maturity Transformation," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 16(4), pages 581-600, October.
    13. Greg Kaplan, 2012. "Moving Back Home: Insurance against Labor Market Risk," Journal of Political Economy, University of Chicago Press, vol. 120(3), pages 446-512.
    14. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
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    Cited by:

    1. Greenwood, Jeremy & Sanchez, Juan M & Wang, Cheng, 2007. "Financing Development: The Role of Information Costs," Staff General Research Papers Archive 12848, Iowa State University, Department of Economics.
    2. Stephane Verani & Till Gross, 2012. "Financing constraints, firm dynamics, and international trade," Finance and Economics Discussion Series 2012-68, Board of Governors of the Federal Reserve System (U.S.).
    3. Wang, Cheng, 2005. "Termination of Dynamic Contracts in an Equilibrium Labor Market Model," Staff General Research Papers Archive 12403, Iowa State University, Department of Economics.
    4. Stephane Verani, 2018. "Aggregate Consequences of Dynamic Credit Relationships," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 29, pages 44-67, July.
    5. Martin Andreasen & Marcelo Ferman & Pawel Zabczyk, 2013. "The Business Cycle Implications of Banks' Maturity Transformation," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 16(4), pages 581-600, October.
    6. Jeremy Greenwood & Juan M. Sanchez & Cheng Wang, 2009. "Financing development : the role of information costs," Working Paper 08-08, Federal Reserve Bank of Richmond.
    7. Li, Shuyun May, 2013. "Optimal lending contracts with long run borrowing constraints," Journal of Economic Dynamics and Control, Elsevier, vol. 37(5), pages 964-983.
    8. Cesar Tamayo, 2015. "Investor protection and optimal contracts under risk aversion and costly state verification," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), pages 547-577.
    9. Jeremy Greenwood & Juan M. Sanchez & Cheng Wang, 2010. "Financing Development: The Role of Information Costs," American Economic Review, American Economic Association, pages 1875-1891.
    10. Shuyun May Li, 2009. "Optimal Lending Contracts with Asymmetric Information and Two-sided Limited Commitment or Impatient Entrepreneur," Department of Economics - Working Papers Series 1065, The University of Melbourne.
    11. Jin, Yu, 2010. "Credit Termination and the Technology Bubbles," MPRA Paper 29010, University Library of Munich, Germany.
    12. Kjetil Storesletten & Chris Telmer & Amir Yaron, 2007. "Asset Pricing with Idiosyncratic Risk and Overlapping Generations," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, pages 519-548.
    13. Stephane Verani, 2018. "Aggregate Consequences of Dynamic Credit Relationships," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 29, pages 44-67, July.
    14. Wang, Cheng, 2011. "Termination of dynamic contracts in an equilibrium labor market model," Journal of Economic Theory, Elsevier, pages 74-110.
    15. Shuyun May Li, 2009. "Optimal Lending Contracts with Long Run Borrowing Constraints," Department of Economics - Working Papers Series 1084, The University of Melbourne.
    16. Storesletten, Kjetil & Telmer, Christopher I. & Yaron, Amir, 2004. "Consumption and risk sharing over the life cycle," Journal of Monetary Economics, Elsevier, pages 609-633.
    17. Hachem, Kinda, 2011. "Relationship lending and the transmission of monetary policy," Journal of Monetary Economics, Elsevier, pages 590-600.

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